Webinar: The regulator says it is time for fund managers to measure, mitigate, manage and monitor outsourced operational risk

AUDIO: An audio replay of the Webinar. Click on the 'Play' button to listen.

By Leon Freytag von Loringhoven

The UK’s Financial Conduct Authority (FCA) recently announced that fund managers can only charge underlying clients for research through trading commissions if it is original and has a meaningful impact on trading decisions. The FCA and its precursor the Financial Services Authority (FSA) said it would review how research costs were being expensed to the fund over 2013 and 2014. The regulator has lived up to its word and now managers have to adapt.


Dominic Hobson: Founder of COOConnect (Moderator)
Dan Schnurr: CTO at Geospatial Insight
Glen Bedwin: COO at Absolute Strategy Research and Director of The European Association of Independent Research Providers (Euro IRP)
Andrea Cenko: Solutions Consultant at Advent Software
Tim O’Halloran: Co-Founder & Managing Director of Westminster Research Associates, Principal at ConvergEx Group
Neil Scarth: Principal at Frost Consulting
Alan Miller: Founder & Partner of SCM Private



• The new set of Financial Conduct Authority (FCA) rules on the use of dealing commissions by fund managers came into effect on 2 June 2014. Managers now have to prove that they have controls in place to govern how they purchase research, and are using equity commissions to buy eligible goods and services with them only, defined as “substantive” research which reaches “meaningful conclusions.”

• Importantly, “corporate access” does not fall within the definition of a “substantive” research which reaches “meaningful conclusions.

• MiFID II (the second iteration of the Markets in Financial Instruments Directive), which is expected to come into effect at the end of 2016, also takes an interest in this issue. Article 24, which governs inducements, effectively forbids payments in cash or kind by a third party that would change the behaviour of the manager. Investment research, purchased from brokers using equity commissions, is an inducement.

• However, the consultation paper on MiFID II published by the European Securities and Markets Authority (ESMA) suggests investment research will be exempt if it is widely distributed, since that reduces its value, limiting its impact on behaviour.

• It follows that research of high value is likely to alter the behaviour of a manager. Though the final outcome cannot be predicted with certainty, this can be taken to mean that the use of equity commissions to buy research will be banned by MiFID as an illegitimate inducement.

• The impact of the FCA and potential MiFID II measures on the market for independent research is hard to predict, but in principle the breaking of the tie between research and other services (including execution) out to be positive for it, since most independent research providers offer nothing but research.

• On the other hand, given the MiFID definition of low value research as research which is widely distributed, the fact that independent research has to be sold for profit on a stand-alone basis means that the information is not widely distributed. In other words, regulatory developments may have the perverse effect of allowing equity commissions to be used to pay for “worthless” research from brokers but not for high value independent research.

• At present, most research is purchased from brokers. Globally, about $2.6 billion are spent on independent research – a mere 15 per cent of the total. In Europe, the percentage is significantly lower, although the United Kingdom figure is close to the global average. Independent research clearly represents a minority, but the proportion seems to be growing

• The best way to assess the quality of research, given the limitations of current understanding, is to look at performance. It also remains the only way the clients can check whether the commission they are paying is justified or not. There is no other tool with which it is possible to measure the value of research (though one is sorely needed).

• Unfortunately, evidence that managers which buy independent (as opposed to tied)  research out-perform those which do not is patchy at best and hard to measure, because a lot of independent research does not provide a binary recommendation to buy or sell a stock

• However, it is probable that research provided by independent providers is superior since (unlike sell-side firms) they run research as a profit rather than a cost centre, and if it is of no value it will not be bought.

• Interestingly, corporates increasingly trust independent research houses more than research analysts tied to major investment banks. This could be a material development, given the regulatory clamp-down on “corporate access.”

• However, fund managers are likely to remain reluctant to sever ties with brokers until regulators force them to do so, because research is only part of a complex relationship encompassing execution allocation, corporate access, market colour and other “inside track” information.

• This is why the bulk of equity commissions continue to spent with the major investment banks: not because the quality of their research products is higher, but because they offer a range of other services as part of a bundle package. Often managers know that they are paying too much for the research, but they do not want to damage their relationships with these brokers. It is an area regulators need to focus on.

• Corporate access is undoubtedly valuable and improves performance. But CEOs and CFOs are increasingly well trained not to inadvertently let slip genuinely inside information. These days, attendees at corporate access meeting aim to gain information by inference, e.g. how a question is answered, how the CFO and the CEO interact, etc.

• Corporate access should, if it is continued at all, be paid for as a logistical service rather than as an investment research service. The market is moving into this direction.

• The United Kingdom regulators are doing more than their American counterparts to change the way in which research is being bought. In the United States, there is no rule forbidding the use of equity commissions to pay for corporate access. In fact, a large proportion of the equity commissions paid to sell-side firms are for either direct corporate access or to meaningful analysis of corporate performance and prospects.

• Global fund managers now purchase research on a global basis, so their research budgets are now being spent in multiple jurisdictions. It will be interesting to monitor whether global managers apply “best practice” from the most highly regulated markets everywhere or follow different regulations on procurement of research in different markets.

• The average large manager is thought to receive about two million documents and emails a year in investment research alone, although they do not open more than 5-10 per cent of them. There is demand for better technology to filter, store and assess the value of all this information.

• Regulatory demands to prove that a manager has controls in place are likely to increase demand for investment research management technologies, but at present managers are not heavy users because they do not yet understand the capabilities.

• It is unlikely that a publicly advertised price will ever be put on investment research. That is because the same piece of research will be of different value to different people.

• It is almost impossible to price research, especially a single piece of research. However, a research service can be priced, e.g. for a period of time. In fact, the FCA recognised that research is not a product, but a service. Access to an analyst, for example, is a service.

• A problem created by reliance on equity commissions (which was identified by the FCA) is that the amount of money spent on research rises automatically in line with the value of assets under management, instead of in line with the quantity (and quality) of research being produced.

• An ideal market would be one in which execution is paid through equity commissions and investment research is paid for through the P&L of the fund manager. MiFID II may force the markets to move in that direction by effectively banning the use of equity commissions to purchase investment research.